Beginning in 2018, under the tax code overhaul, the provisions applicable to pass-through entities provide for 20% of pass-through income to be deducted, subject to certain limitations. The remainder of pass-through income remains subject to taxes at regular rates up to a new top rate of 37% (revised down from 39.6% under prior law).  For persons making more than $157,500 (or $315,000 for a married couple), the deduction is limited or phased out entirely for people in certain “specified service businesses,” including medical, legal and consulting practices (but not architects and engineers).  The limit on the 20% deduction is also capped at 50% of wages paid by the business or 25% of the wages plus 2.5% of the value of the business “qualified property” whichever is greater.  Qualified property is tangible, depreciable property that pass-through businesses use to produce income.

The second alternative for calculating wage limit was added by the Conference Committee and would permit real estate businesses with large capital investments but few employees to qualify for a deduction under this provision.

The adoption by the Conference Committee of the “simpler” Senate version with the 20% deduction for qualified business income avoids revamping of the requirements that pass-through entities pay reasonable compensation.  This also presently leaves in place the practice of permitting the setting of “reasonable” salary, and compensation rates typically in keeping with standards of amounts paid within a particular trade or business industry.  This permits continuation of owner’s control over salary and therefore, amounts of FICA taxes paid on salary.

Further, IRS guidance and regulation may of course complicate this issue, but for smaller businesses and owners with few employees or real estate investment and construction businesses, the availability of this new deduction coupled with continuation of prior pass-through corporate and limited liability benefits prevails and keeps use of Sub-Chapter S elections and limited liability companies as the most tax efficient for owners of small businesses.

A separate primer on Corporations selecting Sub-Chapter S status and limited liability companies taxed as partnerships is included in this alert to our clients.

Article written by Richard Robertson.